For a New Liberty: The Libertarian Manifesto

Inflating by simply printing more money, however, is now considered old-fashioned. For one thing, it is too visible; with a lot of high-denomination bills floating around, the public might get the troublesome idea that the cause of the unwelcome inflation is the government’s printing [p. 179] of all the bills — and the government might be stripped of that power. Instead, governments have come up with a much more complex and sophisticated, and much less visible, means of doing the same thing: of organizing increases in the money supply to give themselves more money to spend and to subsidize favored political groups. The idea was this: instead of stressing the printing of money, retain the paper dollars or marks or francs as the basic money (the “legal tender”), and then pyramid on top of that a mysterious and invisible, but no less potent, “checkbook money,” or bank demand deposits. The result is an inflationary engine, controlled by government, which no one but bankers, economists, and government central bankers understands — and designedly so.

First, it must be realized that the entire commercial banking system, in the United States or elsewhere, is under the total control of the central government — a control that the banks welcome, for it permits them to create money. The banks are under the complete control of the central bank — a government institution — a control stemming largely from the central bank’s compulsory monopoly over the printing of money. In the United States, the Federal Reserve System performs this central banking function. The Federal Reserve (”the Fed”) then permits the commercial banks to pyramid bank demand deposits (”checkbook money”) on top of their own “reserves” (deposits at the Fed) by a multiple of approximately 6 : 1. In other words, if bank reserves at the Fed increase by $1 billion, the banks can and do pyramid their deposits by $6 billion — that is, the banks create $6 billion worth of new money.

Why do bank demand deposits constitute the major part of the money supply? Officially, they are not money or legal tender in the way that Federal Reserve Notes are money. But they constitute a promise by a bank that it will redeem its demand deposits in cash (Federal Reserve Notes) anytime that the depositholder (the owner of the “checking account”) may desire. The point, of course, is that the banks don’t have the money; they cannot, since they owe six times their reserves, which are their own checking account at the Fed. The public, however, is induced to trust the banks by the penumbra of soundness and sanctity laid about them by the Federal Reserve System. For the Fed can and does bail out banks in trouble. If the public understood the process and descended in a storm upon the banks demanding their money, the Fed, in a pinch, if it wanted, could always print enough money to tide the banks over.

The Fed, then, controls the rate of monetary inflation by adjusting the multiple (6: i) of bank money creation, or, more importantly, by [p. 180] determining the total amount of bank reserves. In other words, if the Fed wishes to increase the total money supply by $6 billion, instead of actually printing the $6 billion, it will contrive to increase bank reserves by $i billion, and then leave it up to the banks to create $6 billion of new checkbook money. The public, meanwhile, is kept ignorant of the process or of its significance.

How do the banks create new deposits? Simply by lending them out in the process of creation. Suppose, for example, that the banks receive the $i billion of new reserves; the banks will lend out $6 billion and create the new deposits in the course of making these new loans. In short, when the commercial banks lend money to an individual, a business firm, or the government, they are not relending existing money that the public laboriously had saved and deposited in their vaults — as the public usually believes. They lend out new demand deposits that they create in the course of the loan — and they are limited only by the “reserve requirements,” by the required maximum multiple of deposit to reserves (e.g., 6: i). For, after all, they are not printing paper dollars or digging up pieces of gold; they are simply issuing deposit or “checkbook” claims upon themselves for cash — claims which they wouldn’t have a prayer of honoring if the public as a whole should ever rise up at once and demand such a settling of their accounts.

How, then, does the Fed contrive to determine (almost always, to increase) the total reserves of the commercial banks? It can and does lend reserves to the banks, and it does so at an artificially cheap rate (the “rediscount rate”). But still, the banks do not like to be heavily in debt to the Fed, and so the total loans outstanding from the Fed to the banks is never very high. By far the most important route for the Fed’s determining of total reserves is little known or understood by the public: the method of “open market purchases.” What this simply means is that the Federal Reserve Bank goes out into the open market and buys an asset. Strictly, it doesn’t matter what kind of an asset the Fed buys. It could, for example, be a pocket calculator for twenty dollars. Suppose that the Fed buys a pocket calculator from XYZ Electronics for twenty dollars. The Fed acquires a calculator; but the important point for our purposes is that XYZ Electronics acquires a check for twenty dollars from the Federal Reserve Bank. Now, the Fed is not open to checking accounts from private citizens, only from banks and the federal government itself. XYZ Electronics, therefore, can only do one thing with its twenty-dollar check: deposit it at its own bank, say the Acme Bank. At this point, another transaction takes place: XYZ gets an increase of twenty dollars in its checking account, in its “demand [p. 181] deposits.” In return, Acme Bank gets a check, made over to itself, from the Federal Reserve Bank.

Now, the first thing that has happened is that XYZ’s money stock has gone up by twenty dollars — its newly increased account at the Acme Bank — and nobody else’s money stock has changed at all. So, at the end of this initial phase — phase I — the money supply has increased by twenty dollars, the same amount as the Fed’s purchase of an asset. If one asks, where did the Fed get the twenty dollars to buy the calculator, then the answer is: it created the twenty dollars out of thin air by simply writing out a check upon itself. No one, neither the Fed nor anyone else, had the twenty dollars before it was created in the process of the Fed’s expenditure.

But this is not all. For now the Acme Bank, to its delight, finds it has a check on the Federal Reserve. It rushes to the Fed, deposits it, and acquires an increase of $20 in its reserves, that is, in its “demand deposits with the Fed.” Now that the banking system has an increase in $20, it can and does expand credit, that is, create more demand deposits in the form of loans to business (or to consumers or government), until the total increase in checkbook money is $120. At the end of phase II, then, we have an increase of $20 in bank reserves generated by Fed purchase of a calculator for that amount, an increase in $120 in bank demand deposits, and an increase of $100 in bank loans to business or others. The total money supply has increased by $120, of which $100 was created by the banks in the course of lending out checkbook money to business, and $20 was created by the Fed in the course of buying the calculator.

In practice, of course, the Fed does not spend much of its time buying haphazard assets. Its purchases of assets are so huge in order to inflate the economy that it must settle on a regular, highly liquid asset. In practice, this means purchases of U.S. government bonds and other U.S. government securities. The U.S. government bond market is huge and highly liquid, and the Fed does not have to get into the political conflicts that would be involved in figuring out which private stocks or bonds to purchase. For the government, this process also has the happy consequence of helping to prop up the government security market, and keep up the price of government bonds.

Suppose, however, that some bank, perhaps under the pressure of its depositors, might have to cash in some of its checking account reserves in order to acquire hard currency. What would happen to the Fed then, since its checks had created new bank reserves out of thin air? Wouldn’t it be forced to go bankrupt or the equivalent? No, because the Fed [p. 182] has a monopoly on the printing of cash, and it could — and would — simply redeem its demand deposit by printing whatever Federal Reserve Notes are needed. In short, if a bank came to the Fed and demanded $20 in cash for its reserve — or, indeed, if it demanded $20 million — all the Fed would have to do is print that amount and pay it out. As we can see, being able to print its own money places the Fed in a uniquely enviable position.

So here we have, at long last, the key to the mystery of the modern inflationary process. It is a process of continually expanding the money supply through continuing Fed purchases of government securities on the open market. Let the Fed wish to increase the money supply by $6 billion, and it will purchase government securities on the open market to a total of $i billion (if the money multiplier of demand deposits/reserves is 6:i), and the goal will be speedily accomplished. In fact, week after week, even as these lines are being read, the Fed goes into the open market in New York and purchases whatever amount of government bonds it has decided upon, and thereby helps decide upon the amount of monetary inflation.

The monetary history of this century has been one of repeated loosening of restraints on the State’s propensity to inflate, the removal of one check after another until now the government is able to inflate the money supply, and therefore prices, at will. In 1913, the Federal Reserve System was created to enable this sophisticated pyramiding process to take place. The new system permitted a large expansion of the money supply, and of inflation to pay for war expenditures in World War I. In 1933, another fateful step was taken: the United States government took the country off the gold standard, that is, dollars, while still legally defined in terms of a weight of gold, were no longer redeemable in gold. In short, before 1933, there was an important shackle upon the Fed’s ability to inflate and expand the money supply: Federal Reserve Notes themselves were payable in the equivalent weight of gold.

There is, of course, a crucial difference between gold and Federal Reserve Notes. The government cannot create new gold at will. Gold has to be dug, in a costly process, out of the ground. But Federal Reserve Notes can be issued at will, at virtually zero cost in resources. In 1933, the United States government removed the gold restraint on its inflationary potential by shifting to fiat money: to making the paper dollar itself the standard of money, with government the monopoly supplier of dollars. It was going off the gold standard that paved the way for the mighty U.S. money and price inflation during and after World War II.

But there was still one fly in the inflationary ointment, one restraint [p. 183] left on the U.S. government’s propensity for inflation. While the United States had gone off gold domestically, it was still pledged to redeem any paper dollars (and ultimately bank dollars) held by foreign governments in gold should they desire to do so. We were, in short, still on a restricted and aborted form of gold standard internationally. Hence, as the United States inflated the money supply and prices in the 1950s and 1960s, the dollars and dollar claims (in paper and checkbook money) piled up in the hands of European governments. After a great deal of economic finagling and political arm-twisting to induce foreign governments not to exercise their right to redeem dollars in gold, the United States, in August 1971, declared national bankruptcy by repudiating its solemn contractual obligations and “closing the gold window.” It is no coincidence that this tossing off of the last vestige of gold restraint upon the governments of the world was followed by the double-digit inflation of 1973-1974, and by similar inflation in the rest of the world.

We have now explained the chronic and worsening inflation in the contemporary world and in the United States: the unfortunate product of a continuing shift in this century from gold to government-issued paper as the standard money, and of the development of central banking and the pyramiding of checkbook money on top of inflated paper currency. Both interrelated developments amount to one thing: the seizure of control over the money supply by government.

If we have explained the problem of inflation, we have not yet examined the problem of the business cycle, of recessions, and of inflationary recession or stagflation. Why the business cycle, and why the new mysterious phenomenon of stagflation?